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Author: Dana Peck
Reviewer: Michael Collins
Profit Pools
December 1998Copyright© 1998 Bain & Company, Inc.
2CHI
Profit Pools
Agenda
• Profit Pools Concept
• Applications
• Profit Pool Steps
• Client Example
• Key Takeaways
3CHI
Profit Pools
• Profit pools are the total profits earned in an industry at all points along the industry’s value chain
• Pattern of profit concentration in an industry is very different from the pattern of revenue concentration (see example)
• For example, profits and revenues in the automotive industry can be divided among many value chain activities - vehicle manufacturing, new and used car sales, gasoline retailing, insurance, after-sales service and parts, and lease financing
- although car manufacturing and dealers account for almost 60% of industry revenue
- auto leasing and financing are by far the most profitable businesses
What are Profit Pools?
Profit pools answer the question: “Where and how is money being made?”
Source: Profit Pools: A Fresh Look at Strategy (May-June 1998): Orit Gadiesh and James L. Gilbert
4CHI
Profit Pools
What is Profit?
• Accounting profit - represents company’s earnings as formally reported
- most commonly used as the basic profit measure
- examples include net income or earnings per share calculations
• Return on investment - represents company’s earnings after taking into account the cost of capital invested in the business. Two commonly used measures include:
- ROC, accounting based Return on Capital (book value)
- ROIC, accounting based Return on Invested Capital (book value)
• Cash-flow contribution - company’s earnings before taking fixed-asset and capital costs into account (e.g. EBITDA)
- represents the amount of cash left from a sale after subtracting the variable costs associated with that sale
- used as a basis for decision-making in mature, high fixed cost and cyclical industries
Profit can be defined in one of three ways:
Be aware of differences in accounting standards when evaluating companies with
profits spanning different industries
Source: How to Map Your Industry’s Profit Pool (May-June 1998); Orit Gadiesh and James L. Gilbert
5CHI
Profit Pools
Revenue vs. Profit Split
Truck Finance
Parts and Service
Body Manufacturingand Truck Assembly
Chassis Manufacturingand Sales
Truck Finance
Parts and Service
Body Manufacturingand Truck Assembly
Chassis Manufacturingand Sales
Revenue Split by Activity Profit Split by Activity
$3,865MM $600MM
0%
20%
40%
60%
80%
100%
Per
cent
of
Tot
al
Source: PBIR Profile of the U.S. Truck Body Industry; R.L. Polk Registration Database; Literature Search; TEM Financials; Prior Bain PLP analysis (7/96); Bain estimates
The pattern of profit concentration in the truck manufacturing industry is very different from the pattern of revenue concentration.
Truck Manufacturing Business Example
6CHI
Profit Pools
Why Use Profit Pools?
• Offer a view of the underlying industry structure
• Help illustrate the economic and competitive forces driving the industry’s profit distribution
• Offer a different perspective on an industry
• Illustrate relationship between profit and revenues
• Highlights potential watchouts (choke points in the value chain) which can influence the profit flow in an industry
Illustrate the Current State of the Industry
Provide a Competitive Advantage to Your Client
Help to Develop Innovative Strategies
• Help companies see what their rivals don’t see
• Foster the potential to dictate the terms of competition within the industry
• Keep companies abreast of changes in rapidly changing (turbulent) industries
- alert potential shifts in profit distribution along the value chain
- illustrate potential change in profit sources from new entrants
• Help guide important decisions about a company’s operation and strategy
• Encourage rethinking old decisions and pursuing counterintuitive initiatives to create and control profit pools
• Reduce the possibility of blind spots in a company’s strategic vision
- reduce potential to overlook attractive profit building opportunities
- lesson potential to become trapped in areas of weak/ fading profitability
• Example applications
Companies that recognize the variability of profitability and can exploit the deepest pools will earn superior returns.
Source: Profit Pools: A Fresh Look at Strategy (May-June 1998): Orit Gadiesh and James L. Gilbert
7CHI
Profit Pools
How Profit Pools Illustrate the State of the Industry
• The varying concentrations of profit along the value chain (known as the shape of the profit pool) reflect the competitive dynamics of a business
- profit concentrations result from the actions and interactions of companies and customers
- profit pools form in areas where barriers to competition exist
- profit pools exist in areas that have been overlooked by competitors
• Every market has an uneven distribution of profit between product categories, customer groups, geographic regions and/or distribution channels
• Profit pools are not stagnant
- as power shifts among the players in an industry (competitors, suppliers, and customers), the structure of the profit pool changes
There are many different sources of profit in any business
Profit pools provide a means to evaluate the competitive dynamics of an industry.
Source: Profit Pools: A Fresh Look at Strategy (May-June 1998): Orit Gadiesh and James L. Gilbert
8CHI
Profit Pools
Profit Pool Watchouts (Computer Industry Example)
Examples:
Be aware of “choke points” - particular business activities that control the flow of profits throughout an industry.
Impact:
Control of a choke point can influence the distribution of profits among competitors and
more distant value-chain participants
• Intel’s dominance of microprocessors
• Establishment of an industry wide standard that all companies must now obey
• Microsoft’s dominance of Windows
• Consolidation of control over the customer interface
*includes operating system and application softwareSource: Profit Pools: A Fresh Look at Strategy (May-June 1998): Orit Gadiesh and James L. Gilbert
Micro-processors
Other Components
Personal Computers Software* Peripherals Services
9CHI
Profit Pools
Mic
ro-
proc
esso
rs Other Components
Personal Computers Soft-ware
PeripheralsServices0%
10%
20%
30%
40%
Ope
ratin
g M
argi
n
Share of Industry Revenue
Profit Pool Watchouts (Computer Industry Example Con.)
*includes operating system and application softwareSource: Profit Pools: A Fresh Look at Strategy (May-June 1998): Orit Gadiesh and James L. Gilbert
• Analyzing the profit pool has enabled Dell to be profitable in the least profitable personal computers segment (see example)
Although choke points exist in the computer industry, it is still possible for companies to create and leverage new profit pools within this industry.
PC Industry Profit Pool
100%
10CHI
Profit Pools
0%
5%
10%
15%
20%
25%
Ope
ratin
g M
argi
n
The automotive industry encompasses many value-chain activities. The most profitable areas of the car business are not the ones that generate the biggest revenues.
Auto manufacturing
New
car
de
aler
s Used car dealers
Aut
o lo
ans
Leas
ing
Gas
olin
e Auto insurance
Ser
vice
rep
air
Afte
rmar
ket
part
s
Aut
o re
ntal
Share of Industry Revenue
100%
U.S. Auto Industry Example
11CHI
Profit Pools
Key Questions to Help Develop Innovative Strategies
• Why have profit pools formed where they have?
• Are the forces that created those pools likely to change?
• Will new, more profitable business models emerge?
• How do some profit sources exert influence over others and shape competition?
• How do we gain a disproportionate share of industry profits?
Building an understanding of profit pools puts strategic thinking on a firm footing and prompts the following questions:
Source: Profit Pools: A Fresh Look at Strategy (May-June 1998): Orit Gadiesh and James L. Gilbert
12CHI
Profit Pools
Agenda
• Profit Pools Concept
• Applications
• Profit Pool Steps
• Client Example
• Key Takeaways
13CHI
Profit Pools
Applications (1 of 2)
• Analyzing profit pools allowed U-Haul to identify a large untapped source of profit in the low margin truck rental business
- seized the first mover advantage and entered accessory business at a low cost- reduced prices (and profits) in core truck rental business to attract customers for higher margin
accessory business
• In anticipation of a potential reconfiguration of the profit pool from pharmacy-benefit managers (PBM), Merck and others vertically integrated the value chain and acquired PBMs
- insulated themselves from new entrants and protected their existing sources of profits- gained greater access to patient information- increased the likelihood that the pool would evolve in a beneficial rather than destructive way
Companies can use their understanding of profit pools in different ways:
Identify New Sources of Profit
Chart Acquisition and Expansion Strategies
Examples
Source: Profit Pools: A Fresh Look at Strategy (May-June 1998): Orit Gadiesh and James L. Gilbert
14CHI
Profit Pools
Applications (2 of 2)
• Dell Computer Corp. utilizes the profit pool approach to evaluate which customers to pursue and which channels to use - direct sales approach allows Dell to keep a portion of dealer’s profits for itself and to share the rest with customers
through lower prices- regular resegmentation of customer base enables them to identify the most profitable customers and react quickly to
new sources of profit
• After recognizing that the industry’s profit pool was driven by the premium beer segments, Anheuser Bush refocused their strategy to expand their share of the premium segment
- gained dominance of the premium segment through increased marketing of premium brands and by managing the price differentials between premium and discount brands
- vertical integration into can production raised competitive barriers around the pool by cutting manufacturing and distribution cost
Develop Distribution Strategy
Guide Pricing, Product and
Operating Decisions
The company that sees what others do not will be best prepared to capture a
disproportionate share of industry profits
Source: Profit Pools: A Fresh Look at Strategy (May-June 1998): Orit Gadiesh and James L. Gilbert
15CHI
Profit Pools
Agenda
• Profit Pools Concept
• Applications
• Profit Pool Steps
• Client Example
• Key Takeaways
16CHI
Profit Pools
Mapping a Profit PoolMapping a profit pool involves four steps.
Define the PoolDetermine the
Size of the Pool
Estimate the Distribution of
Profits
Reconcile the Estimates
Tasks: • Identify which value chain activities influence the industry’s ability to generate current and future profits
• Develop a baseline estimate of the profits generated by all profit pool activities within the value chain
• Determine the profits generated by each activity within the value chain
• Compare the results of step 2 and 3, and reconcile the numbers
• List of value chain activities in profit pool (in sequential order)
• Estimate of total profit pools (maybe a range)
• Point estimates of profit for each value chain activity
• Final estimates of activity and total pool profits
Output:
Step 1: Step 2: Step 3: Step 4:
Source: How to Map Your Industry’s Profit Pool (May-June 1998); Orit Gadiesh and James L. Gilbert
17CHI
Profit Pools
Guidelines (Defining the Pool)Defining the pool involves identifying value chain activities relevant to the business.
• Take a broad view of the value chain - look beyond traditional industry definitions
• Examine the industry from 3 perspectives- client- competitors- customers
• Talk to industry players and analysis to uncover new or emerging business models
• Don’t disaggregate activities more than necessary
• Consider parallels from other industries- are there activities that could substitute for activities in this industry?
The way you define your profit pool is unlikely to coincide with any traditional industry
definition
Source: How to Map Your Industry’s Profit Pool (May-June 1998); Orit Gadiesh and James L. Gilbert
18CHI
Profit Pools
Guidelines (Determining the Size of the Pool)
Determining the size of the pool involves developing a rough, but accurate baseline estimate based on the available data.
• Take the easiest analytical routes available
• Focus on the largest components first- large companies
start with the biggest players who account for a large portion of the industry’s profits
gauge the profits of the smaller players by adjusting the leader’s margins to account for the smaller player’s competitive advantages or disadvantages
add the profits together
- high volume products
• Consider building estimates using two different methodologies (e.g. company level vs. product level) so you can compare answers to see if you are in the ball park range
Source: How to Map Your Industry’s Profit Pool (May-June 1998); Orit Gadiesh and James L. Gilbert
19CHI
Profit Pools
Guidelines (Estimating the Distribution of Profits)
Estimating the profits for each value chain involves creative thinking.
• Go where the data is (e.g. products, customers, channels, companies, or regions, etc.)
- use proxies if relevant data is unavailable
• Prioritize focus - look at client economics, then large pure players, large mixed players, then a sample of smaller players
- use the 80/20 rule - in most cases 20% of the companies constitute 80% of the revenues
• Shift between aggregation and disaggregation in analysis
- aggregations - use in industries where most of the players focus on one value chain activity “Pure players”
- disaggregation - you will need to disaggregate company’s financial data if the industry’s players are vertically integrated “mixed players”
Source: How to Map Your Industry’s Profit Pool (May-June 1998); Orit Gadiesh and James L. Gilbert
20CHI
Profit Pools
Guidelines (Reconciling the Estimates)Developing final estimates of activity and total profits can be an iterative process.
Compare the estimate of total profit pools (top-down approach) with estimates calculated for each value
chain activity (bottoms-up approach)
Check assumptions and calculations if the numbers don’t add up
Collect additional data if necessary
Resolve inconsistencies
Source: How to Map Your Industry’s Profit Pool (May-June 1998); Orit Gadiesh and James L. Gilbert
21CHI
Profit Pools
Agenda
• Profit Pools Concept
• Applications
• Profit Pool Steps
• Client Example
• Key Takeaways
22CHI
Profit Pools
Truck Manufacturing Business Example
Activities:
Performed By:
• Provide parts for truck chassis and body
• Perform preventative and emergency service on truck chassis and body
• Build truck body to customer specs
• Prepare body for and manage assembly process
• Sell body to customer• Deliver integrated unit to customer
• Offer funds as loans for truck purchase
• Arrange loan and lease transactions
• Sell chassis to/take order from customer
• Manage connection of chassis and TEM*
• Build truck chassis according to customer specs
• Collect components from manufacturers
• Chassis manufacturer• Chassis dealer• Independent garage or parts store
• TEM • Chassis dealer
• Chassis manufacturer
• TEM
• Chassis dealer• Chassis
manufacturer • TEM
• Chassis manufacturer
Chassis Manufacturing
Chassis Sales
Body Manufacturing,
Sales and Assembly
Parts & Service
Retail Finance
Notes: *Truck Equipment Manufacturers
The first step was to define the pool by identifying the value chain activities relevant to the business.
Severe Service Value Chain (Defining the Pool)
23CHI
Profit Pools
Other
Freightliner
Navistar
Peterbilt
Sterling
Mack
~$500-700MM
0%
20%
40%
60%
80%
100%
Est
imat
ed P
erce
nt o
f T
otal
Pro
fit P
ools
Severe Service Vehicle Profit Pool (Determining the Size of the Pool)
Source: Bain analysis
• Estimated profits from top 5 companies based on 10Ks and annual reports
• Performed 80/20 analysis to determine total profit pool
- assumed 20% of the companies constituted 80% of the profits
- estimated profits of remaining 20 smaller companies
• Reality checked estimates with rough industry calculations
- Estimated total profit pool around $500-$700MM based on:
$3.9B industry revenues
assumed average gross margins of 13%- 18%
Methodology
Truck Manufacturing Business Example
A rough estimate of the total profit pool was built using overall profit estimates from the top 5 competitors.
24CHI
Profit Pools
Note: Operating Margin used as the measure of profitabilitySource: Company Financials; Analysts Reports; Company Interviews
TotalIndustry
McNeilus Heil LeachKnapheideOmaha Vactor Ottawa Advance Rest ofIndustry
7.1%
12.0%
9.0% 9.0% 8.6% 8.2%
6.6%5.8%
3.0%3.9%
0%
3%
5%
8%
10%
13%
Ope
ratin
g M
argi
ns f
or B
ody
Com
pani
es
Profit estimates were generated for each activity based on the operating margins of the top industry players.
Truck Manufacturing Business Example
Example Activity: Body Manufacturing
Body Company Margins (Determining the Distribution of Profits for an Activity within a Value Chain)
25CHI
Profit Pools
Other
Freightliner
Navistar
Peterbilt
Sterling
Mack
Truck FinanceBody Manufacturingand Truck Assembly
Parts andService
ChassisManufacturing
and Sales
Top Down Bottoms Up
~$500-$700MM $600MM
0%
20%
40%
60%
80%
100%
Est
imat
ed P
erce
nt o
f T
otal
Pro
fit P
ools
Severe Service Vehicle Profit Pool (Reconciling the Estimates)
Source: Bain analysis
• Chassis + Parts & Services + Body Manufacturing + Finance the range approximated in the top down approach
Final estimates for each value chain activity is within the range of our original total profit pool estimate
Truck Manufacturing Business Example
Total profit estimates from the top down approach were compared to those from the bottoms up approach.
26CHI
Profit Pools
OtherGeneral Motors
VolvoKenworth
Freightliner
Navistar
Peterbilt
Sterling
Mack
Cha
ssis
De a
ler s
Other
OttawaAdvance Mixer
VactorOmaha
StahlLeach
Knapheide
McNeilus
Heil
Cha
ssis
Dea
lers
Cha
ssis
Man
ufac
ture
rs
ChassisDealers
Chassis Manufacturing ChassisSales
BodyManufacturing,
Sales andAssembly
TruckFinance
Parts Service
$305MM $35MM $60MM $55MM $85MM $60MM
Total EBIT=$600MM
0%
20%
40%
60%
80%
100%
Per
cent
of T
otal
Con
trib
utio
n in
Eac
h A
ctiv
ity
Once the estimates were reconciled, the final profit map enabled the client to see which segments were the most profitable and which controlled the majority of profit pool.
Estimated Margin: 12.3% 1.4% 7.1% 24.6% 11.2%
Truck Manufacturing Business Example
35.0%
Source: PBIR Profile of the U.S. Truck Body Industry; R.L. Polk Registration Database; Literature Search; TEM Financials; Prior Bain PLP analysis (7/96); Bain estimates
Severe Service Vehicle Profit Map (1997)
27CHI
Profit Pools
Dealer ownership would create access
to high margin activities
Chassis manufacturing and after market parts
are most profitable activities
High fragmentationand low profitability
make body manufacturing
unattractive
Body joint venturesattractive if lead togreater chassis or after market share
Dealers control access to high margin
finance and parts and service
Forward integration into bodies has
not occurred
Client should focus on gaining share in
chassis manufacturing and/or capturing a
greater percentage of truck finance and parts
and service
The profit map helped the client evaluate potential markets and their forward integration strategy.
Truck Manufacturing Business Example
Profit Pool Summary
28CHI
Profit Pools
Agenda
• Profit Pools Concept
• Applications
• Profit Pool Steps
• Client Example
• Key Takeaways
29CHI
Profit Pools
•Profit pools are the total profits earned in an industry at all points along the industry’s value chain
•Companies that recognize the variability of profitability and can exploit the deepest pools will earn superior returns
•Building an understanding of profit pools puts strategic thinking on firm footing• illustrates the current state of the industry•provides a competitive advantage to the client•helps develop innovative strategies
•There are many different sources of profit in any business
•Control of a choke points can influence the distribution of profits among competitors and more distant value chain participants
Profit Pools ConceptKey Takeaways (1 of 2)
30CHI
Profit Pools
Profit Pool Steps
Key Success Factors
•Key success factors include: taking a broad view of the value chain, examining the industry from different perspectives, building estimates from multiple perspectives, prioritizing focus to look at the largest and easiest components first, looking at relevant internal and external comparables, gathering and analyzing data, and creative thinking
•There are four steps in developing a profit map:
•Define the pool
•Determine the size of the pool
•Estimate the distribution of profits
•Reconcile the estimates
Key Takeaways (2 of 2)
31CHI
Profit Pools
Takeaway Slides
Profit Pool Concept Profit Pool Uses
Profit Pool Steps Profit Pool Map
3Prof it Pools
b cCHI
• Profit pools are the total profits earned in an industry at all points along the industry’s valuechain
• Pattern of profit concentration in an industry is very different from the pattern of revenueconcentration (see example)
• For example, profits and revenues in the automotive industry can be divided among manyvalue chain activities - vehicle manufacturing, new and used car sales, gasoline retailing,insurance, after-sales service and parts, and lease financing
- although car manufacturing and dealers account for almost 60% of industry revenue
- auto leasing and financing are by far the most profitable businesses
What are Profit Pools?
Profit Pools
Profit pools answer the question:“Where and how is money being
made?”
Source: Profit Pools: A Fresh Look at Strategy (May-June 1998): Or it Gadiesh and James L. Gilbert 6Prof it Pools
b cCHI
Why Use Profit Pools?
Profit Pools
• Offer a view of theunderlying industrystructure
• Help illustrate the economicand competitive forcesdriving the industry’s profitdistribution
• Offer a different perspectiveon an industry
• Illustrate relationshipbetween profit andrevenues
• Highlights potentialwatchouts (choke points inthe value chain) which caninfluence the profit flow inan industry
Illustrate the Current State of the Industry
Provide a Competitive Advantage to Your Client
Help to Develop Innovative Strategies
• Help companies see whattheir rivals don’t see
• Foster the potential to dictatethe terms of competitionwithin the industry
• Keep companies abreast ofchanges in rapidly changing(turbulent) industries- alert potential shifts in profit
distribution along the valuechain
- illustrate potential changein profit sources from newentrants
• Help guide importantdecisions about a company’soperation and strategy
• Encourage rethinking olddecisions and pursuingcounterintuitive initiatives tocreate and control profit pools
• Reduce the possibility of blindspots in a company’s strategicvision
- reduce potential tooverlook attractive profitbuilding opportunities
- lesson potential to becometrapped in areas of weak/fading profitability
• Example applications
Companies that recognize the variability ofprofitability and can exploit the deepest pools willearn superior returns.
Source: Profit Pools: A Fresh Look at Strategy (May-June 1998): Orit Gadiesh and James L. Gilbert
14Prof it Pools
b cCHI
Mapping a Profit PoolMapping a profit pool involves four steps.
Define the PoolDetermine the
Size of the Pool
Estimate theDistribution of
Profits
Reconcile theEstimates
Tasks: • Identify whichvalue chainactivities influencethe industry’sability to generatecurrent and futureprofits
• Develop a baselineestimate of theprofits generatedby all profit poolactivities within thevalue chain
• Determine theprofits generatedby each activitywithin the valuechain
• Compare theresults of step 2and 3, andreconcile thenumbers
• List of value chainactivities in profitpool (in sequentialorder)
• Estimate of totalprofit pools (maybea range)
• Point estimates ofprofit for eachvalue chain activity
• Final estimates ofactivity and totalpool profits
Output:
Step 1: Step 2: Step 3: Step 4:
Profit Pools
Source: How to Map Your Industry’s Profit Pool (May-June 1998); Or it Gadiesh and James L. Gilbert 24Prof it Pools
b cCHI
Severe Service Vehicle Profit Map (1997)
OtherGeneral M otors
Volvo
Kenworth
Freightliner
Navistar
Peterbilt
Sterling
Mack
Chas sisDealers
Other
OttawaAdvance Mixer
Vactor
Omaha
Stahl
Leach
Knapheide
McNeilus
Heil
ChassisDealers
ChassisManufacturers
ChassisDealers
Chassis Manufacturing ChassisSal es
BodyManuf ac tur ing ,
Sa les andAssemb ly
TruckFinance
Parts Service
$305MM $35M M $60MM $55MM $85MM $60MM
Total EBIT=$600MM
0%
20%
40%
60%
80%
100%
Per
cent
of
Tot
al C
ontr
ibut
ion
in E
ach
Act
ivity
Once the estimates were reconciled, the final profit mapenabled the client to see which segments were the mostprofitable and which controlled the majority of profit pool.
Est imated Margin: 12.3% 1.4% 7.1% 24.6% 11.2%
Profit Pools Truck Manufacturing Business Example
35.0%
Source: PBIR Profile of the U.S. Truck Body Industry; R.L. Polk Registration Database; Literature Search; TEMFinancials; Prior Bain PLP analysis (7/96); Bain estimates